Current Yield

Bank Loans Are Beating Bonds

The biggest winner in fixed income isn't really fixed income—bank loans made to firms with credit problems. These leveraged loans have a profile similar to high-yield bonds, but with more opportunity for near-term growth.

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Correction:An earlier version of this column incorrectly listed the PowerShares Senior Loan Portfolio (BKLN) as a closed-end fund. It is an exchange-traded fund.

In a forgettable quarter for bonds, when the Barclays Aggregate index finished with a 0.13% loss, leveraged loans emerged as the star income asset class.

What made leveraged loans a fixed-income standout is that they're not really fixed income at all. They consist of bank loans made to companies with speculative-grade ratings, and they offer floating interest rates that are tied to the London interbank offered rate. While fixed-rate bonds could suffer losses when prevailing interest rates rise, loans offer a welcome hedge.

But rates haven't risen meaningfully yet. Instead, investors are loading up on loans ahead of an expected long-term rise, and in the meantime they're earning a 5.1% average yield, pretty compelling these days even in a neutral rate environment.

Mutual funds and exchange-traded funds that invest in bank loans took in $15.2 billion in first-quarter net inflows, according to Lipper data, versus just $12.2 billion in all of 2012. The average loan price rose from 96.8 cents to 98.1 cents on the dollar, per Standard & Poor's Leveraged Commentary & Data unit, to start the quarter, making loans a rare income investment not yet trading above par value.

The 2.11% quarterly return for loans still trailed the 2.85% tally for their kindred asset class, junk bonds. But the average junk bond, which yields just 5.62%, now trades at 105.3 cents on the dollar, per Bank of America Merrill Lynch, near its record high and above the 103-cent level at which many bonds can be called early. It's hard to envision prices going higher. Lower, yes.

Bob Worthington, president of Hatteras Funds, which has increased its loan holdings recently, says, "The market for bank loans is giving you the same type of yield [as junk bonds], but they're higher in the capital structure, and you're better protected in case something happens to the company." He notes that credit quality is similar at a time when the default rate remains below average.

AN ESTIMATED TWO-THIRDS of loan demand comes from collateralized loan obligations. These investment vehicles pool loans and divide payouts into different classes, or tranches, that let investors customize their exposure to loan risk and return. CLO issuance, which was dormant in the wake of the financial crisis, is burgeoning again.

Compared with older CLOs, the newer versions have less leverage and are "cleaner," according to Mark Okada, chief investment officer at Highland Capital Management, which has $13 billion in loan assets under management.

"CLOs don't have to sell" in the event of a broader market selloff, Okada says. "So much more of the high-yield market is owned by mutual funds and ETFs, and they can be forced sellers. High yield is much more vulnerable to liquidity issues because of who owns it." That said, Highland in February launched the
Highland/iBoxx Senior LoanSNLN 0.2618504449350116%Highland/iBoxx Senior Loan ETFU.S.: NYSE Arca19.03
0.04970.2618504449350116%
/Date(1438376400102-0500)/
Volume (Delayed 15m)
:
92571
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
3.955081450341566% Rev. per Employee
N/AMore quote details and news »SNLNinYour ValueYour ChangeShort position
ETF (ticker: SNLN).

While loans are shielded from duration risk, the flip side is that issuers can call and reprice loans at just about any time. "Given the well-documented absence of call protection in the loan market, current price levels invite further refinancing and repricing activity," Barclays analysts wrote last week.

Treasuries had another good week, thanks again in large part to the Cyprus banking sector. The 10-year yield finished the week at 1.852%, down from 1.915% the week before and barely up from 1.834% at the start of the quarter.